COST OF PROJECT AND MEANS OF FINANCING

COST OF PROJECT AND MEANS OF FINANCING

    A project is concerned finance is the basic prerequisite.  Without proper financial arrangement an entrepreneur is finding difficult to go ahead with his project.  Funds requirement should be optimum so as to avoid the problems of both under and over capitalisation.  So the cost project should be accurately estimated.  Once the estimation of cost of project is over, the next step is to find out the sources of financing.  After identifying the various available sources, a finance mix should be finalised.  The selected finance mix should be optimum from the point of view of cost, control and flexibility.

COST OF PROJECT
    The cost of project represents the total of all items of outlay associated with a project which are supported by long-term funds.  The major cost elements of a project are the following:
Land and site development
Buildings and civil works
Plant and machinery
Technical know-how and engineering fees
Expenses on foreign technicians and training for Indian technicians abroad.
Miscellaneous fixed assets
Preliminary and capital issue expenses
Margin money for working capital
Initial cash losses

Land and site development
    This includes basic cost of land, premium payable on lease hold, cost of levelling and development, cost of laying approach roads, cost of gates, cost of tube wells etc.  The cost of land varies considerably from one location to another location.  Similarly the expenditure on site development also varies according to topography of the land.

Buildings and civil works
    This includes buildings for the main plant and equipment, building for auxiliary services like work shops, laboratory etc., godowns, warehouses, quarters for staff etc.  The cost of buildings and civil works depends on the kinds of structures required.  Once the kinds of structures required are specified, cost estimates are based on the plinth area and rates for various types of structures.

Plant and machinery
    The cost of plant and machinery is the most significant component of the project cost.  This includes the cost of imported machinery and its allied cost, cost of indigenous machinery, cost of stores and spares and installation and foundation charges.  The cost of the plant and machinery is based on the latest available quotation adjusted for possible escalation.

Technical know-how and Engineering fees
    Often it is necessary to engage technical consultants or collaborators from India and/or abroad for advice and help in various technical matters like preparation of the project report, choice of technology, selection of the plant and machinery, and so on.  So the amount payable for obtaining the technical know-how and engineering services for setting up the project is an important component of the project cost.

Expenses on foreign technicians and training of Indian technicians abroad
    Services of foreign technicians may be required in India for setting up the project and supervising the trial runs.  Expenses on their travel, boarding, and lodging along with their salaries and allowances must be shown here.  Likewise, expenses on Indian technicians who require training abroad must also be included here.

Miscellaneous fixed assets
    Fixed assets which are not part of the direct manufacturing process may be referred to as miscellaneous fixed assets.  They include items like furniture, office machinery and equipment, tools, vehicles, railway sidings, diesel generating sets, transformers, boilers, piping systems, laboratory equipments etc.  Expenses incurred for the procurement or use of patents, licenses, trade marks, copyrights, etc and deposits made with electricity board may also be included here.

Preliminary and capital issue expenses
    Expenses incurred for identifying the project, conducting market survey, preparing feasibility report, drafting memorandum and articles of association and incorporating the company are referred to as preliminary expenses.
    Expenses borne in connection with the raising of capital from the public are referred to as capital issue expenses.  The major components of capital issue expenses are: underwriting commission, brokerage, fees to managers and registrars, printing and postage expenses, advertising and publicity expenses, listing fees, and stamp duty.

Pre-operative expenses
    Some revenue expenses incurred till the commencement of commercial production are referred to as pre-operative expenses.  This includes establishment expenses, rent, rates and taxes, travelling expenses, interest and commitment charges on borrowings, insurance charges, mortgage expenses, interest on deferred payments, start-up expenses, and miscellaneous expenses.

Provision for contingencies
    A provision for contingencies is made to provide for certain unforeseen expenses and price increases over and above the normal inflation rate which is already incorporated in the cost estimates.

Margin money for working capital
    The principal support for working capital is provided by commercial banks and trade creditors.  However, a certain part of the working capital requirement has to come from long-term sources of finance.  Referred to as the ‘margin money for working capital’, this is an important element of the project cost.

Initial cash losses
    Most of the projects incur cash losses in the initial years.  Yet, promoters typically do not disclose the initial cash losses because they want the project to appear attractive to the financial institutions and investing public.  Failure to make a provision for such cash losses in the project cost generally affects the liquidity position and impairs the operations.

MEANS OF FINANCING
To meet the cost of project the following means of finance are available:
share capital
term loans
debenture capital
deferred credit
incentive sources
miscellaneous sources

Share capital
 There are two types of share capital-equity capital and preference capital.  Equity capital represents the contribution made by the owners of the business, the equity shareholders, who enjoy the rewards and bear risks of ownership.  Equity capital being the risk capital carries no fixed rate of dividend.  Preference capital represents the contribution made by preference shareholders and the dividend paid on it is generally fixed.

Term Loans
Term loans are provided by financial institutions and commercial banks represents secured borrowings which are a very important source for financing new projects as well as expansion, modernization, and renovation schemes of existing firms.  There are two broad types of term loans available in India: rupee term loans and foreign currency term loans.  While the former are given for financing land, building, civil works, indigenous plant and machinery, and so on, the latter are provided for meeting the foreign currency expenditures towards the import of equipment and technical know how.

Debenture capital
Debentures are instruments for raising debt capital.  There are two broad types of debentures: convertible debentures and non convertible debentures.  Convertible debentures as the name implies, are debentures which are convertible, wholly or partly, in to equity shares.  The conversion period and price are announces in advance.

Deferred credit
Many a time the suppliers of plant and machinery offer a deferred credit facility under which payment for the purchase of plant and machinery can be made over a period of time.

Incentive sources
The government and its agencies may provide financial support as inventive to certain types of promoters or for setting up industrial units in certain locations. These incentives may be in the form of seed capital assistance, capital subsidy or tax exemption for a certain period.

Miscellaneous sources: A small portion of project finance may come from miscellaneous sources like unsecured loans, public deposits, and leasing and hire purchase finance.  Unsecured loans are typically provided by the promoters to bridge the gap between the promoter’s contribution and the equity capital the promoters can subscribe to.  Public deposits represent unsecured borrowings from the public at large.  Leasing and hire purchase finance represent a form of borrowing different form the conventional term loans and debenture capital.


Factors affecting selection of means of finance
The selection of means of finance governs the following considerations:
a) Norms of regulatory bodies and financial institutions
b) Key business considerations

Norms of Regulatory bodies and financial institutions
In many countries, including India, the proposed means of financing for a project must be either approved by a regulatory agency or conform to certain norms laid down by the government or financial institutions in this regard.  The primary purpose of such regulation is to impart prudence to project financing decisions and provide a measure protection to investors.

Key business considerations
The key business considerations which are relevant for the project financing decision are: cost, risk, control and flexibility.

Cost In general the cost of debt fund is lower than the cost of equity funds.  The primary reason is that the interest payable on debt capital is a tax-deductible expense whereas the dividend payable on equity capital is not.

Risk The main sources of risk for a firm are: business risk and financial risk.  Business risk refers to the variability of earning before interest and taxes and arises mainly from fluctuations in demand and variability of prices and costs.  Financial risk represents the risk arising from financial leverage.  It must be emphasized that while debt capital is cheap it is also risky because of the fixed financial burden associated with it.

Control From the point of view of promoters of the project, the issue of control is important.  They would ordinarily prefer a scheme of financing which enables them to maximise their control, current as well as potential, over the affairs of the firm, given their commitment of funds to the project.

Flexibility This refers to the ability of a firm to raise further capital from any source it wishes to tap to meet the future financing needs.  In most practical situations, flexibility means that the firm does not exhaust fully its debt capacity.
WORKING CAPITAL
    Working capital is the amount of money required by an enterprise for carrying out its day to day operations.  The money invested in current assets like raw materials, finished products, debtors etc is known as working capital.  The current assets in aggregate refer to gross working capital and the excess of current assets over current liabilities are called net working capital.  The working capital is of two types: permanent working capital and variable working capital.  Usually the permanent working capital is financed by long-term source of finance and variable working capital by short-term sources.  The short-term sources of finance primarily include the following:
1.Loans from banks
2.Public deposits
3.Trade credit
4.Pledging and factoring
5.Bank overdraft
6.Cash credit
7.Bills discounting
8.Advances from customers
9.Accruals

PLANNING CAPITAL STRUCTURE
    Project financing is usually discussed after project selection.  But, in practice project financing is considered from the time of project conception.  Indeed project financing is tangled with project planning, analysis, and selection.  As the project proposal progresses through the stages of planning, analysis, and selection, the outline of project financing become clearer.

    A capital project involves investment in land, plant and machinery, miscellaneous fixed assets, technical know-how, distribution network, and working capital.  Hence capital project may be regarded as a mini firm.  So the issues to be considered in financing a project are identical to those considered in financing a business firm.

Capital Structure
    The two broad sources of finance available to a firm are:  shareholder’s funds and loan funds.  Shareholder’s funds come mainly in the form of equity capital and retained earnings and secondarily in the form of preference capital.  Loan funds come in a variety of ways like debenture capital, term loans, deferred credit, public deposit and working capital advance.
    Ignoring the preference capital the basic differences between shareholder’s funds and loan funds are as follows:
Equity
Debt
Equity shareholders have a residual claim on the income and the wealth of the firm
Creditors have a fixed claim in the form of interest and principal payment
Dividend paid to equity shareholders is not a tax deductible payment
Interest paid to creditors is a tax deductible payment
Equity ordinarily has an indefinite life
Debt has a fixed maturity
Equity investors enjoy the exclusive privilege to control the affairs of the firm
Debt investors play a passive role- of course; they impose certain restrictions on the way the firm is run to protect their interest.

Key Factors in Determining the Debt – Equity Ratio
    The key factors in determining the debt-equity ratio for a project are:
a)cost
b)nature if assets
c)business risk
d)norms of lenders
e)control consideration and
f)market conditions

Cost
    Compared to equity shareholders, lenders require lower rate of return.  This advantage gets magnified when the firm pays taxes, because the interest on debt is a tax deductible expense whereas the dividend on equity is not.  Even though the cost of debt is low, it is accompanied by a higher rate of risk.

Nature of assets
    The nature of firm’s assets has an important bearing on its capital structure.  If the assets are primarily tangible, debt finance used is more.  On the other hand, if the assets are primarily intangible debt finance used is less. Usually the lenders are more willing to lend against tangible assets and less inclined to lend against intangible assets.

Business risk
    Business risk refers to the variability of earning power.  Business risk mainly come from demand variability, price variability, variability of input prices and proportion of fixed operating costs.  Generally the affairs of the firm should be managed in such a way that the total risk borne by equity shareholders, which consist of business risk and financial risk, is not unduly high.  This implies that if the firm is exposed to a high degree of business risk, its financial risk should be kept low.

Norms of Lenders
    The norms employed by the lenders have a bearing on the capital structure.  Generally the debt-equity ratio norm allowed by financial institutions is 1:1.  But for highly capital intensive projects they permit a higher debt-equity ratio.

Control considerations
    The extent of equity stake that promoters want to have in a project has an important bearing in its capital structure.  So the promoters make a choice between equity and debt in such a way as to not loose their desired control over the project.

Market conditions
    If the market is attractive and equity shares can be issued at an attractive premium, the project may rely more on equity.  On the other hand, in the equity market is depressed, the project may rely more on debt.
Choice between equity and debt
Use more equity when
Use more debt when
The tax rate applicable is negligible
The tax rate applicable is high
Business risk exposure is high
Business risk exposure is low
Dilution of control is not an important issue
Dilution of control is an issue
The assets of the project are mostly intangible
The assets of the project are mostly tangible
The project has many growth options
The project has few growth options